Which Bull Market is Weary?

MARK SORGENFREI JR.

Oct. 9 marked the five-year anniversary of the record closing high of the S&P 500. With the S&P 500 getting within 3 percent of that closing high last week on a total return basis, many investors wonder if this current equity bull market has any legs left.

Time will tell, but there is another bull market that has a high probability of reaching the finish line soon. Investors always need to be looking at the full investment landscape when making decisions about their capital. First, investors must get over the no-risk/no duration cash hurdle. Many investors are still hesitant to clear this bar. Cash as a percent of total household financial assets has come down from the March 2009 peak, but it is still at very elevated levels, roughly equaling the levels of the October 2002 stock market bottom.

A quick glance at the year-to-date interest return on a savings account reveals that cash is not compelling if the investor needs return to outpace inflation. Moving past the cash hurdle requires risk, and many have chosen to deploy the risk capital into Treasury bonds that have a maturity of two to 30 years. These bonds are an attractive investment for jittery investors since there is essentially zero default risk (Washington debt ceiling debates notwithstanding).

However, Treasury bonds still have interest rate risk, and that is where the glaring danger lies. Bond prices and interest rates have an inverse relationship. As interest rates fall, bond prices rise. Conversely, if interest rates rise, bond prices fall. To see the sign of a bull market that might be running on fumes, take a look at Treasury bonds. The 10-year Treasury bond yield was at 15.85 percent on Sept. 30, 1981. It has been downhill from there for the past 31 years, as the 10-year yield on Sept. 30, 2012, was 1.65 percent. That is a very long, very powerful bull market for Treasury bonds, with falling rates providing a severe tailwind for Treasury investors.

However, toss in a 2 percent current core inflation rate, and the real yield on a 10-year Treasury bond today is now negative, translating into a loss of purchasing power for Treasury holders. Looking forward is where the warning signs are flashing. If the 10-year rate rises by 1 percent to a mere 2.65 percent level, then that will result in a capital loss of 9 percent.

The 30-year Treasury bond story is even worse, as a 1 percent rise above its Sept. 30, 2012, yield of 2.82 percent results in a capital loss of 20 percent. A higher surge results in higher losses. The longer end of the yield curve can rise and fall in spite of the Fed’s efforts, especially from today’s low levels. As evidence, see the quick 0.48 percent rise in the 10-year Treasury yield that occurred from July 25 to Aug. 16 of this year.

If economic and consumer confidence data in the U.S. begin surprising more consistently to the upside, upward Treasury yield pressure could be the norm, rather than the exception.